Starbucks (SBUX) has been a global pioneer in the coffee industry. Cafes, a niche market prior to Starbucks, are now a global trend thanks to Starbucks’ efforts to popularize coffee and coffee-based beverages.
Starbucks has taken a dominant position in the US, and is expanding rapidly around the world, including in China. Shareholders of SBUX stock have been rewarded with great gains. The question is, will the good times continue? Here are three reasons for optimism, along with a few potential drawbacks.
Starbucks Stock Pros
Great Winter Sales: This was an excellent holiday quarter for Starbucks. Unlike much if not most of the United States’ retail and restaurant industry, Starbucks put up fantastic numbers. Same stores sales in the US were up 9%, a rather incredible figure for a company with such a mature group of stores. And much of that was driven by increased number of consumer visits, rather than mere price increases.
Overall revenues were up 12%, maintaining the sort of rapid growth SBUX stock owners have come to expect, despite the weakening global economy.
App Gives Competitive Edge: Starbucks has had, for a physical restaurant chain, unprecedented success with its digital app. The company’s digital app now accounts for 21% of its total store transactions. That’s an extraordinarily high percentage in the fast food/restaurant industry.
The already successful app is making a big leap forward. SBUX rolled its nationwide mobile order and pay system out last fall. This quarter, it already accounted for 6 million orders monthly, still only a few percent of total orders. However, it is being adopted quickly by consumers.
For particularly busy locations, such as midtown New York, long lines have stopped Starbucks from reaching its full same store sales growth potential for years. During rush times, such as early morning, Starbucks often has such long lines that only the most brand-devout would wait 15 minutes for a coffee rather than buying one from a competitor with no line.
The mobile order and pay system offers the potential to boost Starbucks’ business during peak hours significantly — and that’s great news for SBUX stock.
Much International Potential Remains: China is already Starbucks’ second-largest market, though it still trails the United States by a significant margin. SBUX said the Chinese economy’s struggles slowed momentum in the most recent quarter, though overall Asia-Pacific region sales were up a healthy 5%.
Starbucks doesn’t break out China sales specifically, though Starbucks’ CEO commented that he eventually sees China quite possibly being a larger market than even the US. I’d also note that a significant market opportunity is on offer in Latin America, particularly as average wages rise in that region.
But, that doesn’t mean SBUX stock doesn’t have potential downsides…
Starbucks Stock Cons
Very High Valuation: SBUX stock is currently going for a 36 P/E ratio. That is extremely expensive compared to the broader S&P 500 index of stocks, which trade at 20 times earnings. Starbucks has seen its shares rise more than tenfold since the low during the financial crisis. Much of that appreciation was well-earned, however some of the gains in stock price appear to be from overvaluation rather than fundamental growth.
It is worth considering that another good growth story in the same coffee arena, Dunkin Brands (DNKN) trades at a much lower valuation ratio. Dunkin is at 23 P/E ratio and offers an attractive 2.8% dividend yield on its shares. Starbucks, by comparison, only offers a rather decaffeinated 1.4% yield.
Shares Vulnerable To A Recession: SBUX stock can lose much of its value during a broader market rout. Starbucks shares fell by roughly 3/4ths during the 2008-09 bear market, far exceeding the broader market’s loss.
Starbucks tends to fall into the consumer defensive category in most investors’ minds. However coffee isn’t quite as necessary as traditional foods. Coffee is addictive, but not to the extent that alcohol or cigarettes are. And while coffee is a daily habit, it isn’t quite as essential as toothpaste or toilet paper.
As the high-priced luxury good within the space, Starbucks is especially vulnerable to economic weakness. Yes, luxury coffee will hold up better than many things, but don’t think Starbucks is immune to a bear market. Just look what happened during the last one. Especially with SBUX stock’s valuation already being stretched, any drop in investor sentiment could send shares reeling.
Margin Pressures: There are two significant sources of potential margin pressure for Starbucks. The first of these is the persistently strong US dollar, which hurts overseas revenue. The Euro and various Latin American currencies have already been in a state of steady devaluation over the past year. This reduces the margin Starbucks gets on its sales in those regions. Now with China starting to devalue its currency as well, Starbucks’ second-most important market by sales will see its profitability start to decline due to currency.
And on the cost side, one should be alert for a potential rebound in the price of coffee. Coffee futures are around $1.18/lb, more or less the lowest level this contract has recorded in more than twenty years. While the cost of coffee isn’t actually that large of a portion of Starbucks’ costs, a reversion to a more normal price for green coffee beans would still be a significant drag.
Verdict
Starbucks has been one of the NASDAQ’s best growth stories from 2009 onward. But this isn’t the moment where you want to get on board. SBUX stock is significantly overvalued, and potential margin pressures are looming. The positives are nice, but with the global economy slowing, the downside in shares seems to more than outweigh the potential benefits from the app and international growth at this juncture.
At this time of this writing, Ian Bezek had no positions in any of the securities mentioned. You can reach him on Twitter at @irbezek.
